Why Bond Funds Could Get Dicey This Year

By

Tom Lauricella

January 6, 2013

The new year is just a few days old, but for mutual-fund investors, the bond market already is proving tricky to navigate.

On the surface, 2013 looks like it ought to be a safe environment for bond mutual funds. The Federal Reserve is expected to keep interest rates at rock bottom so the odds of a bear market should be slim.

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But U.S. Treasury prices started the year by tumbling—to the surprise of many—after last week's down-to-the-wire deal in Washington to avert the so-called fiscal cliff.

Having avoided the worst of the automatic tax increases, the country is now expected to avoid an economic slowdown and instead post moderate growth. That, in turn, spooked some investors worried about inflation and the possibility that the Fed might move sooner to raise rates. Bond prices move in the opposite direction of bond yields.

At the same time, however, much riskier high-yield bonds surged to fresh record highs.

The start of 2013 shows that bond-fund investors need to be on their toes. It's an outlook where it may pay for investors to be cautious, but not completely defensive.

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Christoph Hitz

That means paring back areas which have had big rallies in recent years, such as high-yield bond funds, which are up an average of 10.5% over the last three years, according to Morningstar. It also means beginning to trim bond funds that will take a big hit whenever interest rates finally rise.

Whatever the bond-fund strategy, yields are already extremely low across most major markets. That calls for a penny-pinching approach to mutual-fund fees. For most investors that means focusing on lower cost index-based strategies, such as exchange-traded funds.

"It's a lot harder to earn returns in the bond market in this environment," says Thomas Tzitzouris, head of fixed-income research at Strategas Research Partners.

More than perhaps ever before, bond investors in 2013 need to keep a close watch on the Federal Reserve as it continues an unprecedented effort to juice the U.S. economy by pumping freshly minted money into the financial markets.

For bond investors, the Fed's efforts present both good and bad news. On the one hand, the Fed's actions will likely keep bond yields from rising in 2013. The efforts by the Fed have helped fuel long-term government-bond funds to an average annual gain of 15% over the last three years, according to Morningstar.

The bad news is that yields on U.S. government bonds are being capped at what many in the market say will ultimately prove to be unsustainably low levels given expectations for higher inflation.

Without the Fed, "yields would be much higher," says Mr. Tzitzouris.

In other words: Putting money into a U.S. Treasurys-heavy bond fund will be a losing bet. The U.S. Treasury 10-year note is yielding 1.91%, up from 1.88% at the start of 2012.

For example, should the yield on the 30-year U.S. Treasury bond rise just one percentage point from where it was at year-end, the value of that bond would fall roughly 20%, according to data compiled by Vanguard Group.

Many money managers also have grown nervous about continuing to pile money into investment-grade and high-yield corporate bonds.

At Boston-based Windhaven Investment Management, which oversees $13.5 billion in portfolios constructed out of ETFs, the firm has pared back profitable positions in both investment-grade and high-yield bonds.

However, Mr. Cucchiaro sees opportunities for bond investors elsewhere around the globe, particularly emerging markets. Bond markets in countries such as South Korea, Mexico or Indonesia offer higher yields along with a brighter fiscal outlook than in the U.S. and other big developed countries—a positive for bond investors.

One way advisers are playing emerging-market bonds is with the WisdomTree Emerging Markets Local Debt Fund (ELD). This fund focuses on bonds issued by countries in their local currencies. Local debt funds offer opportunity for additional returns should the U.S. dollar weaken against emerging-market currencies.

However, that can come with substantial additional short-term swings in the value of the investment, thanks to moves in the currency markets.

One option for earning more attractive yields while lessening the risks are funds aimed at short-term, high-yield debt, says Mark DiOrio, portfolio manager at Parasol Investment Management in Westmont, Ill. "You're not giving up much yield" compared with long-term, high-yield bond funds, he says.

For example, the Pimco 0-5 Year High Yield Corporate Bond Index ETF (HYS) is yielding 3.7%.

Another option for collecting yield but managing risks of a future increase in interest rates are ETFs designed to mature just like individual bonds. These funds allow investors to build a "bond ladder" where the funds mature at specific dates in the future when money will be needed. At the same time, the funds provide greater diversification and ease of trading than individual bonds.

A measure of 10-20 year Treasury bonds returned 4.2% in 2012, according to Barclays. Because expenses eat away at returns, a shareholder in an actively managed fund with that portfolio would get 80% of the returns, but an index-fund investor would pocket 91%.

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